Are Wall Street Salaries a Scourge?

SMITH BRAIN TRUST – Since the financial crisis, Wall Street has garnered a reputation – and some sharp criticism – for its lucrative salary structures. Analysts, policymakers and academics have, at turns, chided the industry, accusing it of helping to distort the “efficient allocation of talent” in the economy.

The industry’s cushy compensation packages, the criticism goes, are draining talent from other, more productive jobs across the economy – entrepreneurship and scientific research, as examples – and that’s ultimately holding down growth in the broader economy.

In new research, experts from the University of Maryland’s Robert H. Smith School of Business bring data to the criticism, creating a dataset that spans 13 industries in 24 countries from 1970 to 2005.

The Smith School’s Francesco D’Acunto and Laurent Frésard collaborated on the research, now a working paper. They found that as finance sector wages climbed through the years, there was “a modest reallocation” of workers from productive non-finance sectors to that industry. But the negative repercussions largely assigned to that shift, they found, couldn’t be quantified.

The research revealed “virtually no effect” on growth from the reallocation of talent, neither at the sector level or the national level, explains D’Acunto, assistant professor of finance at the Smith School.

“We show that, on average, growing finance wages is not a big issue because when finance wages grow usually the contribution of finance to the rest of the economy grows as well, in terms of more efficient allocation of resources and more capital available to other sectors,” he says.

“Many observers believe that growing finance salaries are to blame for creating the recent financial crisis. Our results suggest that growing finance salaries do not lead to financial and economic crises as long as they are matched with a higher contribution of finance to the rest of the economy,” Frésard says.

Frésard and D’Acunto, who are circulating the draft for peer review, say the findings may help shift “the uni-directional debate” about spillover effects from escalating salaries in the finance sector. In their research, D’Acunto and Frésard controlled for education level and other factors across various countries, sectors and years.

They note that the financial sector has grown considerably in size around the world over the past four decades, and compensation has expanded considerably as well.

“Consistent with earlier within-country evidence, we detect a reallocation of skilled workers from non-finance sectors into finance when the finance wage premium is high. Yet the magnitude of this reallocation is modest,” the researchers say in the paper.

“Crucially,” the study finds, “reallocation appears too low to hinder sectoral or aggregate economic growth, research productivity, and innovation, which we measure using several proxies and over various horizons. Reallocation does not materially affect the riskiness, efficiency, or competitiveness of the banking sector either. Higher finance wages per se do not seem to hinder growth or worsen the quality of a country’s banking sector.”

The question has been explored before. But in this latest research, the professors did something innovative – adjusting the growth of finance wages – which is frequently interpreted as reflecting rents in finance – by the contribution of finance to the economy. “This adjustment is important,” the researchers say “because the finance compensation and the contribution of finance are positively correlated in our sample.”

“Growing finance wages are often proposed as evidence of increasing rents in the financial sector. However, higher finance wages might at times reflect a higher contribution of finance to the rest of the economy,” the paper says.

The researchers say their findings also point to the importance of considering cross-country sector data and over an extended time period when addressing questions on economy-wide factor reallocation and growth.

“Focusing on policy experiments limited in space and time is crucial to pinpoint causal relationships,” they say, “but assessing external validity and overall magnitudes using broader and more representative settings also provides relevant insights.”

About the Expert(s)

Laurent Frésard is an Associate Professor of Finance at the Robert H. Smith School of Business at the University of Maryland. His research interests are mainly in empirical corporate finance, with a focus on the interactions between product market competition and corporate policies, and the determinants and consequences of international cross-listings. His work has recently been published the Journal of Finance, Journal of Financial Economics, Review of Financial Studies, and Review of Finance. Professor Frésard's teaching interests include corporate finance, and valuation. Prior to joining the University of Maryland, Professor Frésard was on the faculty at HEC Paris.

Francesco D'Acunto is an Assistant Professor of Finance at the Smith School of Business of the University of Maryland. His research interests focus on empirical corporate finance, entrepreneurial finance and innovation, and cultural finance. Prior to joining the Smith School, D'Acunto earned a M.Sc. and Ph.d. in finance from the Haas School of Business, UC Berkeley, and a M.A. in Economics and Business Law from the Università di Tor Vergata, Italy.

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